What Is an Annuity? A Plain-English Definition

Every annuity is a written contract issued by a life insurance company. Four roles appear in it. The owner buys the contract, controls it, and pays the tax. The annuitant is the person whose life expectancy sets the payment schedule; usually the owner and annuitant are the same person, but a couple can name one spouse as owner and the other as annuitant. The beneficiary receives whatever value remains when the annuitant or owner dies. The insurer is the company that holds the money and makes the promises.

The promise is what separates an annuity from an investment account. A brokerage account holds assets that rise and fall; an annuity holds a contractual guarantee. That guarantee is only as strong as the company behind it, which is why financial strength ratings from AM Best, S&P, Moody's and Fitch matter more for an annuity than for almost any other product you will buy.

Takeaway: You are not buying a fund. You are buying a promise from a specific insurance company, so the company's strength is part of the product.

A deferred annuity has an accumulation phase, when your premium grows inside the contract, and a payout phase, when the insurer pays money back to you. You choose when the payout phase begins; it can be years away. An immediate annuity skips accumulation: you hand over a lump sum and payments begin within about a year, usually the next month.

During accumulation the contract has a cash value you can see on your statement. Most deferred annuities let you withdraw a portion each year, commonly 10% of the value, without a surrender charge. Larger withdrawals during the surrender period cost a percentage that declines each year until it reaches zero.

The payout phase can take one of two shapes. Annuitization converts the contract into a fixed schedule of payments, often for life, and usually gives up access to the remaining lump sum. An income rider, sold on many fixed index and variable annuities, pays a guaranteed lifetime withdrawal while the account value stays yours. The two produce different amounts and different flexibility, and the difference matters more than most buyers realize.

Annuities differ in how the money grows and when it pays out. The names below are the ones you will see on quotes and in contracts.

• Fixed annuity: the insurer credits a declared interest rate. A multi year guaranteed annuity (MYGA) locks one rate for a set term, usually 2 to 10 years, and works much like a certificate of deposit inside an insurance wrapper.
• Fixed index annuity (FIA): interest is linked to an index such as the S&P 500, with a floor of 0% so a down year does not reduce your principal, and a cap or participation rate that limits the upside.
• Registered index-linked annuity (RILA): index-linked like an FIA, but you accept a defined share of losses (a buffer or floor) in exchange for higher upside limits. RILAs are securities, sold with a prospectus.
• Variable annuity: your premium is invested in sub-accounts similar to mutual funds; the value moves with the markets, and guarantees come only from optional riders that carry annual fees.
• Single premium immediate annuity (SPIA): a lump sum bought today for payments that start within a year, for life or for a set number of years.
• Deferred income annuity (DIA) and qualified longevity annuity contract (QLAC): a lump sum bought today for payments that start years later; a QLAC is a DIA bought with retirement-account money under special IRS rules.

Takeaway: Fixed, MYGA, FIA and SPIA contracts are insurance products; RILAs and variable annuities are also securities and come with a prospectus.

When you annuitize, you pick a payout option. Life only pays the highest amount but stops at death, even if that is next year. Life with period certain pays for life, and guarantees a minimum number of years (10 or 20 are common) to your beneficiary if you die early. Joint and survivor pays as long as either spouse is alive, at a lower monthly amount. Period certain only pays for a fixed number of years with no life contingency.

Payment amounts depend on your age, sex in most states, the option you choose, current interest rates, and the size of the premium. Older buyers receive more per dollar because the insurer expects to pay for fewer years. That is also why the same $100,000 produces a different monthly figure at 60 than at 70.

If you prefer to keep control of the lump sum, systematic withdrawals or a guaranteed lifetime withdrawal benefit rider deliver income without annuitizing. The tradeoff is a lower guaranteed amount than a life-only annuitization of the same money, in exchange for keeping the account value and the death benefit.

An annuity is not FDIC insured. Its first line of protection is the insurer's own reserves, which state regulators require to be held against every contract. The second line is your state's life and health insurance guaranty association, a safety net funded by the industry that steps in if an insurer becomes insolvent. Coverage for annuity benefits is commonly $250,000 per owner per insurer, though a few states set higher or lower limits, and the association pays only after regulators liquidate the company.

Two consumer protections apply before you ever need the guaranty fund. The free-look period, set by state law and usually 10 to 30 days from delivery, lets you cancel a new contract and get your premium back. And every state requires the agent to have a reasonable basis to believe the annuity suits your needs, under the NAIC suitability and best-interest rules most states have adopted.

Takeaway: Check three things before you sign: the insurer's financial strength rating, your state's guaranty association limit, and the free-look period on the contract.

Money inside a deferred annuity grows without annual tax. When you take earnings out, they are taxed as ordinary income, not at capital gains rates. For a non-qualified annuity (bought with after-tax money), withdrawals are treated as earnings first until all gain is out, and then as a tax-free return of premium. If you annuitize, each payment is split between taxable earnings and a tax-free return of your premium using the IRS exclusion ratio.

Taxable amounts withdrawn before age 59 and a half generally owe a 10% additional federal tax on top of income tax, with exceptions such as death, disability, and payments taken as a series of substantially equal periodic payments. An annuity held inside an IRA or 401(k) follows the retirement account's tax rules instead, and the annuity adds no extra tax deferral there.

Annuities fit people who want part of their retirement money to behave like a pension: a guaranteed rate for a known term, or income they cannot outlive. They are also used to defer tax on money that is already outside a retirement plan, and to protect a portion of savings from market losses in the years around retirement.

They fit poorly when the money may be needed within the surrender period, when the buyer does not understand what is guaranteed and what is not, or when the entire nest egg is put into one contract. Most planners suggest annuitizing only enough to cover essential expenses that Social Security and any pension do not, and keeping the rest liquid.

• Good fit: guaranteed growth for a fixed term, lifetime income, tax deferral on non-retirement savings, principal protection near retirement.
• Poor fit: money you may need soon, a buyer who has not read the surrender schedule, or a single contract holding most of your savings.

Fixed and fixed index annuities usually have no stated annual fee; the insurer earns its margin from the spread between what it earns and what it credits. Their real cost is the surrender charge, which can start near 7% to 10% and decline over 5 to 10 years, and, for FIAs, the caps and participation rates that limit index gains. Optional income riders add an annual charge, commonly around 1% of the benefit base, on both FIAs and variable annuities.

Variable annuities carry the most explicit costs: mortality and expense charges, sub-account fund fees, and rider fees that together often exceed 2% a year. Every cost should appear in the contract or prospectus, and a licensed specialist can show you the surrender schedule and rider charges side by side before you commit.